* FTSEurofirst 300 up 0.8 pct, Euro STOXX 50 up 1.4 pct
* Madrid's IBEX surges 2.9 percent in massive volumes
* IBEX, Milan's MIB still long way from 2007 highs
* Go 'long' IBEX, 'short' FTSE 100 -SG's Paul Jackson
PARIS, Jan 7 European stocks rallied on Tuesday to hit 5 1/2-year highs as investors betting on economic recovery in southern Europe scooped up shares from the region.
Spain's IBEX index led the rally, surging 2.9 percent in volumes that were more than twice the size of an average session. Bankinter rose 5 percent, Caixabank 7.2 percent and BBVA 5.7 percent.
"Recent indicators in Spain are quite encouraging, with house prices stabilising, which allows investors to see light at the end of the tunnel," Valquant strategist Eric Galiegue said.
Madrid's bourse has been outperforming this week, after data showed the country's service sector grew at its fastest pace in 6 1/2 years in December, sparking expectations that the economy could expand more than expected in 2014.
Construction group Sacyr also rallied on Tuesday, rising 4.7 percent after the Panama Canal authority proposed an end to a dispute with a consortium fronted by Sacyr.
The FTSEurofirst 300 index of top European shares ended 0.8 percent higher, at 1,319.74, its highest closing level since mid-2008. The euro zone's blue-chip Euro STOXX 50 index gained 1.4 percent, Italy's FTSE MIB 1.2 percent and Portugal's PSI 20 2.5 percent, also in heavy trading volumes.
Portugal's Banco Espirito Santo rose 5.7 percent and Italy's Banco Popolare 5.6 percent.
French banks, which have exposure to southern Europe, also rallied. Credit Agricole added 6.1 percent and Societe Generale gained 4 percent.
Bucking the trend, Swedish Match dropped 5.5 percent. Citigroup analysts cut their recommendation on the stock to 'sell' from 'neutral', citing further pricing pressures ahead from competition.
Shares in Solvay dropped 3.3 percent after the Belgian chemical group's chief executive gave cautious comments about the start of 2014.
Despite sharp gains in the past six months, southern European bourses have yet to recover from their debt crisis selloffs. Germany's DAX is trading at record highs, but Madrid's IBEX would still need to rally 58 percent to reach 2007 levels. Milan's MIB would need to surge 128 percent.
Paul Jackson, managing director for global macro advisory at Societe Generale, recommends pairing a 'long' position on Spain's IBEX with a 'short' position on Britain's FTSE 100 .
"When you look at valuation discrepancies and what is going on dynamically in terms of the Spanish market and Spanish unit labour cost, Spain is the market that I would favour there."
Today's European research round-up
Asset returns in 2013: